The Investment FAQ is a collection of frequently asked questions and
answers about investments and personal finance. This is a plain-text
version of The Investment FAQ, part 4 of 20. The web site
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Investment FAQ or for any damages (whether direct or indirect,
consequential, punitive or exemplary) resulting therefrom.
Rules, regulations, laws, conditions, rates, and such information
discussed in this FAQ all change quite rapidly. Information given
here was current at the time of writing but is almost guaranteed to be
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--------------------Check http://invest-faq.com/ for updates------------------
Subject: Bonds - Municipal Bond Terminology
Last-Revised: 7 Nov 1995
Contributed-By: Bill Rini (bill at moneypages.com)
These definitions of municipal bond terminology are at best
simplifications. They should only be used as a stepping stone, leading
to further education about municipal bonds.
Act of 1911 and 1915
Used for developments within a particular district and are secured
by special assessment taxes set at a fixed dollar amount for the
life of the bond. 1911 Act Bonds are secured by individual
parcels, while 1915 Act Bonds are secured by all properties within
the district.
Ad Valorem Tax
A tax based on the value of the property
Advance Refunding
The replacement of debt prior to the original call date via the
issuance of refunding bonds.
Authority (Lease Revenue)
A bond secured by the lease between the authority and another
agency. The lease payments from the "city" to the agency are equal
to the debt service.
Callable Bond
A bond that can be redeemed by the issuer prior to its maturity.
Usually a premium is paid to the bond owner when the bond is
called.
Certificate of Participation (COP)
Financing whereby an investor purchases a share of the lease
revenues of a program rather than the bond being secured by those
revenues. Usually issued by authorities through which capital is
raised and lease payments are made. The authority usually uses the
proceeds to construct a facility that is leased to the
municipality, releasing the municipality from restrictions on the
amount of debt that they can incur.
Crossover Refunded
The revenue stream originally pledged to secure the securities
being refunded continues to be used to pay debt service on the
refunded securities until they mature or are called. At that time,
the pledged revenues pay debt service on the refunding securities.
Discount Bond
A bond that is valued at less than its face amount.
Double Barrelled
Bonds secured by the pledge of two or more sources of repayment.
Face Value
The stated principal amount of a bond.
General Obligations
Voter approved bonds that are backed by the full faith, credit and
unlimited taxing power of the issuer.
Mello Roo's
Bonds used for developments that benefit a particular district
(schools, prisons, etc.) and are secured by special taxes based on
the assessed value of the properties within the district. Tax
assessment is included on the county tax bill.
Par Value
The face value of a bond, generally $1,000.
Premium Bond
A bond that is valued at more than its face amount.
Principal
The amount owed; the face value of a debt.
Redevelopment Agency (Tax Allocation)
Bonds secured by all of the property taxes on the increase in
assessed valuation above the base, on properties in the project.
Revenue Bonds
Bonds secured by the revenues derived from a particular service
provided by the issuer.
Sinking Fund
A bond with special funds set aside to retire the term bonds of a
revenue issue each year according to a set schedule. Usually takes
effect 15 years from date of issuance. Bonds are retired through
either calls, open market purchases, or tenders.
Taxable Equivalent Yield
The taxable equivalent yield is equal to the tax free yield divided
by the sum of 100 minus the current tax bracket. For example the
taxable equivalent yield of a 6.50% tax free bond for someone in
the 32% tax bracket would be:
6.5/(100-32) = 0.0955882 or 9.56%
YieldA measure of the income generated by a bond. The amount of
interest paid on a bond divided by the price.
Yield to Maturity
The rate of return anticipated on a bond if it is held until the
maturity date.
This article is copyright 1995 by Bill Rini. For more insights from
Bill Rini, visit The Syndicate:
http://www.moneypages.com
--------------------Check http://invest-faq.com/ for updates------------------
Subject: Bonds - Relationship of Price and Interest Rate
Last-Revised: 28 Oct 1997
Contributed-By: Rich Carreiro (rlcarr at animato.arlington.ma.us), Chris
Lott ( contact me )
The basic relationship between the price of a bond and prevailing market
interest rates is an inverse relationship. This is actually pretty
straightforward. For example, if you have a 6% bond (this means that it
pays $60 annually per $1000 of face value) and interest rates jump to
8%, wouldn't you agree that your bond should be worth less now if you
were to sell it?
If this isn't clear, think about it this way. If the rate of interest
being paid on newly issued bonds stands at 8%, a bond buyer would get
paid $80 annually for each $1,000 investment in one of those bonds. If
that bond buyer instead bought your old 6% bond for the price you
originally paid, that bond would yield $20 less per year when compared
to bonds on the market. Clearly that's not a very attractive offer for
the buyer (although it would be a great deal for you).
To quantify the inverse relationship between the price and the interest
rate, you really need the concept of the present value of money (also
see the article elsewhere in the FAQ on this topic). Computing present
value figures helps you answer questions like "what's better, $95 today
or $100 one year from now?" The beginnings of it go something like this.
Pretend that you have $100. Also pretend that you can invest it in
something that will pay a 5% annual return. So, one year from now you
have:
$100 * (1 + 0.05) = $105
This can be turned around. Let's say that you want to know how much
money you need to have today in order to have $200 a year from now, if
you can earn 5%:
X * (1 + 0.05) = $200 or X = $200/(1 + 0.05) = $190.48
Therefore, we can say that the present value of $200 one year from now,
assuming a "discount rate" (this is what the assumed interest rate in a
present-value calculation is called) of 5% is $190.48.
But what if you wanted to know how much you needed today to have $200
two years from now, again assuming you could earn 5%? Here's the
computation.
[ X * (1 + 0.05) ] * (1 + 1.05) = $200
X represents the original amount, and the quantity "X * (1 + 0.05)"
represents the amount after 1 year. Solving for X we get:
X = 200/(1 + 1.05)^2 = $181.41
So, the present value of $200 two years hence, at a discount rate of 5%
is $181.41. It should be clear that the present value of $200 N years
from now at a discount rate of 5% is:
PV = 200/(1 + 0.05)^N
And this can be generalized to the present value of an amount C, N years
from now, at a discount rate of r:
PV = C/(1 + r)^N
Now you can combine these. Let's say I promise to pay you $300 a year
from today and $500 two years from today. What could I have paid you
today that would have made you just as happy as what I promised? Assume
you can earn 7% on your money. To solve this, just sum the present
value of each payment. This sum is called the "net present value" (NPV)
of a series of cash flows.
NPV = $300/(1+0.07) + $500/(1+0.07)^2 = $717.09
So, given the 7% discount rate, the payments I scheduled are equivalent
to a payment of $717.09 made today.
Let's get a little fancier. What if I'm willing to promise to pay you
$50 per year for 4 years, starting a year from now, and further promise
to pay you $1000 five years from now. What's the most you'd be willing
to pay me now to make you that promise. Assume a discount rate of 6%.
NPV = $50/(1+0.06) + $50/(1+0.06)^2 + $50/(1+0.06)^3 +
$50/(1+0.06)^4 + $1000/(1+0.06)^5 = $920.51
Let's say you want to wait until tomorrow. You have a dream that night
that makes you believe that you'll now be able to earn 10% on your
money. When I come back to you, you now tell me you'll only pay me
NPV = $50/(1 + 0.10) + $50/1.1^2 + $50/1.1^3 + $50/1.1^4 +
$1000/1.1^5 = $779.41
My promise is now worth quite a bit less. You should be able to see
that if your dream had led you to believe you could earn less on your
money, then my promise would have been worth more to you than it did
yesterday.
At this point, it's probably clear that my "promise" is effectively what
a bond is -- I'm agreeing to pay you a fixed amount each year (actually,
the bond would pay half that fixed amount twice a year) and then the
principal amount at maturity. Given what you think you can earn on your
money, the price you should pay for the bond is well-defined. The
question is what affects what you think you'll be able to earn on your
money? Fed policy might. What you think the chances of inflation are
might. Lots of other things might. This is where the fun starts. :-)
Also note that you can turn the equation around. Let's say that you
have a $1000 bond paying $75 per year. The bond matures in 10 years.
Someone is willing to sell it to you for $850. What will I have earned
on my investment? The net present value equation always holds, so $850
equals the net present value of the yearly payments and principal
payment.
Obviously, since we know everything except the discount rate, this
equation must define the discount rate that makes it true. The problem
is that the rate cannot be simply calculated. You must make a guess,
compute the net present value, see how different it is from $850, use
that to adjust your guess, and try again until the sides of the equation
balance. The discount rate you come up with is called the "internal
rate of return" (IRR) and in the bond world is called the "yield to
maturity" (YTM). In fact, if you know the initial value of some
portfolio, all cash flows into and out of the portfolio, and the final
value of the portfolio, you can compute your IRR, thus answering the
common misc.invest.* question of "I put $N into a fund on date X, but
then added $D on date Y and $F on date W. My account is today worth $B.
What's my return?"
As a final note, here's a bit of a stumper to spring on someone:
Assuming you could earn 5% on your money, would you rather be paid $1000
annually (first payment is today, next is a year from now, etc.) forever
(assume you are immortal :-) or $25000 today? Believe it or not, you
should take the $25000 today. Here's the analysis why.
NPV = $1000 + $1000/1.05 + $1000/1.05^2 ...
or
NPV = $1000*(1 + 1/1.05 + 1/1.05^2 + ...)
A math reference book can tell you (or you might remember or derive it)
that the infinite sum:
1 + x + x^2 + x^3 + ... = 1/(1 - x) if |x| < 1
In this case, x = 1/1.05, so
NPV = $1000*[1/(1 - 1/1.05)] = $21000
So believe it or not, you'd be better off taking $25000 today then
taking $1000 per year forever, given the 5% discount rate assumption.
--------------------Check http://invest-faq.com/ for updates------------------
Subject: Bonds - Tranches
Last-Revised: 22 Oct 1997
Contributed-By: (anonymous), Chris Lott ( contact me )
A 'tranche' (derived from the French for 'slice') is used in finance to
define part of an asset that is divided (sliced, hence the term) into
smaller pieces. A common example is a mortgage-backed security. One
bank may only be interested in the payments at the longer end of the
security's maturity, while another investment firm may want only the
cash flows due in the near term. An investment bank can split the
original asset into 'tranches' where each party (the bank and the
investment firm) receive rights to the expected cash payments for
particular periods. The two new assets are repriced, and the investment
bank usually makes a tidy profit. This can be done with many assets,
the goal being better marketablity of typically larger assets. If you
want more information on how this is used in specific, I would think
there would be data on the debt of less developed countries that has
been consolidated, then sold in 'tranches' to investors in the developed
worlds. The London Club is a group of commercial creditors which holds
claim on the debt of Russia, for example.
--------------------Check http://invest-faq.com/ for updates------------------
Subject: Bonds - Treasury Debt Instruments
Last-Revised: 1 Jan 2002
Contributed-By: Art Kamlet (artkamlet at aol.com), Dave Barrett, Rich
Carreiro (rlcarr at animato.arlington.ma.us)
The US Treasury Department periodically borrows money and issues IOUs in
the form of bills, notes, or bonds ("Treasuries"). The differences are
in their maturities and denominations:
Bill Note Bond
Maturity up to 1 year 1--10 years 10--30/40 years
Denomination $1,000 $1,000 $1,000
Minimum purchase $1,000 $1,000 $1,000
Treasuries are auctioned. Short term T-bills are auctioned every
Monday. The 4-week bill is auctioned every Tuesday. Longer term bills,
notes, and bonds are auctioned at other intervals.
T-Notes and Bonds pay a stated interest rate semi-annually, and are
redeemed at face value at maturity. Exception: Some 30 year and longer
bonds may be called (redeemed) at 25 years.
T-bills work a bit differently. They are sold on a "discounted basis."
This means you pay, say, $9,700 for a 1-year T-bill. At maturity the
Treasury will pay you (via electronic transfer to your designated bank
checking account) $10,000. The $300 discount is the "interest." In this
example, you receive a return of $300 on a $9,700 investment, which is a
simple rate of slightly more than 3%.
The best way for an individual to buy or sell Treasury instruments is
via the US Treasury's "TreasuryDirect" program, which provides for
no-fee/low-fee transactions. Please see the article elsewhere in this
FAQ for more information about using the TreasuryDirect program. Of
course treasuries can also be bought and sold through a bank or broker,
but you will usually have to pay a fee or commission to do this, not to
mention maintain an account.
Treasuries are negotiable. If you own Treasuries you can sell them at
any time and there is a ready market. The sale price depends on market
interest rates. Since they are fully negotiable, you may also pledge
them as collateral for loans. (Note that if the securities are held by
the Treasury as part of their TreasuryDirect service, then they cannot
be used as collateral.)
Treasury bills, notes, and bonds are the standard for safety. By
definition, everything is relative to Treasuries; there is no safer
investment in the U.S. They are backed by the "Full Faith and Credit"
of the United States.
Interest on Treasuries is taxable by the Federal Government in the year
paid. States and local municipalities do not tax Treasury interest
income. T-bill interest is recognized at maturity, so they offer a way
to move income from one year to the next.
The US Treasury also issues Zero Coupon Bonds. The ``Separate Trading
of Registered Interest and Principal of Securities'' (a.k.a. STRIPS)
program was introduced in February 1986. All new T-Bonds and T-notes
with maturities greater than 10 years are eligible. As of 1987, the
securities clear through the Federal Reserve's books entry system. As
of December 1988, 65% of the ZERO-COUPON Treasury market consisted of
those created under the STRIPS program.
However, the US Treasury did not always issue Zero Coupon Bonds.
Between 1982 and 1986, a number of enterprising companies and funds
purchased Treasuries, stripped off the ``coupon'' (an anachronism from
the days when new bonds had coupons attached to them) and sold the
coupons for income and the non-coupon portion (TIGeRs or Strips) as
zeroes. Merrill Lynch was the first when it introduced TIGR's and
Solomon introduced the CATS. Once the US Treasury started its program,
the origination of trademarks and generics ended. There are still TIGRs
out there, but no new ones are being issued.
Other US Debt obligations that may be worth considering are US Savings
Bonds (Series E/EE and H/HH) and bonds from various US Government
agencies, including the ones that are known by cutesy names like Freddie
Mac, as well as the Mae sisters, Fannie, Ginnie and Sallie.
Historically, Treasuries have paid higher interest rates than EE Savings
Bonds. Savings Bonds held 5 years pay 85% of 5 year Treasuries.
However, in the past few years, the floor on savings bonds (4% under
current law) is higher than short-term Treasuries. So for the short
term, EE Savings Bonds actually pay higher than treasuries, but are
non-negotiable and purchases are limited to $15,000 ($30,000 face) per
year.
US Government Agency Bonds, in general, pay slightly more interest but
are somewhat less predictible than Treasuries. For example,
mortgage-backed-bond returns will vary if mortgages are redeemed early.
Some agency bonds, technically, are not general obligations of the
United States, so may not be purchased by certain institutions and local
governments. The "common sense" of many people, however, is that the
Congress will never allow any of those bonds to default.
In October 2001, the Treasury Department announced that it was
suspending issuance of the 30-year bond and had no plans to issue that
security ever again.
--------------------Check http://invest-faq.com/ for updates------------------
Subject: Bonds - Treasury Direct
Last-Revised: 2 Oct 2001
Contributed-By: Art Kamlet (artkamlet at aol.com), Bob Johnson, Rich
Carreiro (rlcarr at animato.arlington.ma.us)
Treasury securities can be purchased directly from the US Treasury using
a service named "TreasuryDirect." The minimum purchase for any Treasury
security that can be obtained via the TreasuryDirect program is $1,000.
There are no fees for accounts below $100,000; accounts in excess of
that sum are charged a $25 annual fee. Interest payments can be made
directly to an individual's TreasuryDirect account. Further, mature
Treasury securities can be used to purchase new ones. Investors can do
business with the TreasuryDirect program via the web, phone, or plain
old mail.
The "Direct To You" services offered by the US Treasury have made
transactions in the TreasuryDirect program very attractive for private
investors. First, the Treasury can debit a bank account for the amount
of the purchase after the instrument's price is set by the auction (the
"Pay Direct" service). This means that an investor pays exactly the
right amount, unlike the old system in which an investor was forced to
send in a check for the full face value and wait for a refund. Second,
investors can sell instruments before their maturity dates using the
"Sell Direct" service. The Treasury charges $34 for brokering the sale
of a Treasury instrument, which reportedly is less than the fee charged
by banks and brokerage houses. The instrument is sold using the Federal
Reserve Bank of Chicago, which is responsible for getting a fair price.
Third, holders of Treasury instruments can reinvest funds from maturing
instruments simply by using the telephone or the web along with the
information that appears on a notice sent to holders of maturing
instruments (the "Reinvest Direct" service).
Investors can get more information about the TreasuryDirect program
either by calling 800-722-2678 or visiting the web site:
http://www.treasurydirect.gov
--------------------Check http://invest-faq.com/ for updates------------------
Subject: Bonds - U.S. Savings Bonds
Last-Revised: 4 Mar 2003
Contributed-By: Art Kamlet (artkamlet at aol.com), Gordon Hamachi, Rich
Carreiro (rlcarr at animato.arlington.ma.us), M. Persina, David
Capshaw, Paul Maffia (paulmaf at eskimo.com), J. Zinchuk (jzinchuk at
draper.com), Chris Lott ( contact me )
This article describes US Savings Bonds issued by the US Treasury, and
discusses how they can be purchased or redeemed. Because the US
Treasury changes the rules for these bonds periodically, this article
also gives some information about determining the yields of bonds issued
over the past 30 years.
US Savings bonds are obligations of the US government. Interest paid on
these bonds is exempt from state and local income taxes. Savings Bonds
are not negotiable instruments, and cannot be transferred to anyone at
will. They can be transferred in limited circumstances, and there could
be tax consequences at the time of transfer.
Two types of US Savings Bonds are offered, namely Series EE Bonds and
I Bonds. The I Bond was introduced in 1998 and is indexed for
inflation. The Treasury plans to sell both types of bonds on an ongoing
basis; there are no plans for one or the other to be phased out.
US Savings bonds can be purchased from commercial banks, through an
employer via payroll deductions, or (naturally) over the internet. Most
commercial banks act as agents for the Treasury; they will let you fill
out the purchase forms and forward them to the Treasury. You will
receive the bonds in the mail a few weeks later. See the foot of this
article for the web site that allows on-line purchases.
Savings bonds can be redeemed (cashed in) at many banks or directly with
a branch of the Federal Reserve Bank. Using your bank, credit union, or
savings and loan is probably the fastest way to cash a bond, but be
certain to call ahead to ask (you might need to bring certain
documentation). In some cases, the bank may send the bonds to the Fed,
which will slow things down. If your bank will not cooperate, contact
the appropriate Fed branch to redeem bonds by mail or via the web (see
links at the end of this article).
Series EE bonds are purchased at half their face value or denomination.
So you would purchase a $100 Series EE Bond for $50. I Bonds are
purchased at face value or denomination. So you would purchase a $100
I Bond for $100.
You can buy up to $15,000 (your cost; actually $30,000 face value) of
Series EE Bonds per year. If you buy bonds with a co-owner, the two of
you can together buy up to twice that limit, but even so, no more than
$30,000 (face amount) in EE bonds purchased in one calendar year may be
attributed to one co-owner (so you cannot evade the limits by using many
different co-owners). You can buy up to $30,000 of I Bonds per year.
The Series EE andI Bond limits are independent of each other, meaning an
individual could give Uncle Sam up to $45,000 annually to buy bonds.
Series EE Bonds earn market-based rates that change every 6 months.
There is no way to predict when a Series EE bond will reach its face
value. For example, a Series EE Bond earning an average of 5% would
reach face value in 14 1/2 years while a bond earning an average of 6%
would reach face value in 12 years.
I Bonds are an accrual-type security. In English, this means that
interest is added to the bond monthly. The interest is paid when the
bond is cashed. An I Bond earns interest for as long as 30 years. The
interest accrues on the first day of the month, and is compounded
semiannually. The earnings rate of an I Bond is determined by a fixed
rate of return plus a semiannual inflation rate. The fixed rate (as the
name might imply) remains the same for the life of an I Bond. The
semiannual inflation rate (the bonus) is announced each May and
November, and is based on the Consumer Price Index (CPI), as calculated
by the wizards at the Bureau of Labor Statistics (ooh!).
Series EE Bonds and I Bonds issued after 1 February 2003 must be held
for at least 12 months before they can be cashed (bonds issued before
then could be cashed anytime after 6 months). If an investor cashes an
I Bond within the first five years, the investor is penalized by losing
three months worth of interest. For example, if you cash an I Bond
after exactly twelve months, you will receive just nine months worth of
interest. This "feature" of the I Bond is supposed to encourage
long-term investment.
Series EE Bonds absolutely should be cashed before their final maturity
dates for the following reasons. Firstly, if you fail to cash the
Series EE bond (or roll it over into an Series HH Bond) before the
critical date, you will be losing money because the bond will no longer
be earning interest. Secondly, under IRS regulations, tax is due on the
interest in the year the bond is cashed or it reaches final maturity.
If you hold the bond beyond 12/31 of the final-maturity year, then when
you finally get around to cashing it, you will not only owe the tax on
the earnings, but interest and penalties besides. Thirdly, once the
bond passes its final maturity date (as for example a year later) you
cannot roll the proceeds into an HH to further postpone tax on the
accumulated interest.
Interest on a Series EE/E Bond or I Bond can be deferred until the bond
is cashed in, or if you prefer, can be declared on your federal tax
return as earned each year. When you cash the bond you will be issued a
Form 1099-INT and would normally declare as interest all funds received
over what you paid for the bond (and have not yet declared). This is
what they mean by deferring taxes.
If you with to defer the tax on the interest paid by a Series EE Bond at
maturity yet further, you can do so by using the proceeds from cashing
in a Series EE Bond to purchase a Series HH Savings bond (prior to 1980,
H Bonds). You can purchase Series HH Bonds in multiples of $500 from
the proceeds of Series EE Bonds. Series HH Bonds pay interest every 6
months and you will receive a check from the Treasury. When the HH bond
matures, you will receive the principal, and a form 1099-INT for that
deferred EE interest.
At the time of purchase, a bond can be registered to a single person
("single ownership"), registered to two people ("co-ownership"), or can
be registered to a primary owner and a beneficiary ("beneficiary"). In
the case of co-ownership, either named individual can do whatever they
like with the bond without consent for the other person; if one dies,
the other becomes the single owner. In the case of beneficiary
registration (bond is marked POD for "payable on death"), the primary
owner controls the bond, and ownership passes to the beneficiary if the
primary owner dies.
Ownership of Series EE bonds (but not I-Bonds) can be transferred, for
example if a grandparent wants to give a grandchild some money. A
transfer in ownership (called a "reissue" by the US Treasury) where a
living person who was an owner relinquishes all ownership of a bond is a
taxable event. This means that the person giving the bonds (the
"principal owner") incurs a tax liability for the accrued interest up to
the date of transfer and must pay Uncle Sam. It's essential to keep
good records until the time when the beneficiary finally cashes the
bonds in. Recall that all interest on the bond is paid when it's cashed
in. Because someone paid some tax on that interest already, the person
cashing the bond should not pay tax on the full amount. Alternatively,
the grandparent could just add the grandchild as a co-owner, which
doesn't result in anyone incurring a tax liability at the transfer.
Interest from Savings Bonds can excluded if used to pay higher education
expenses such as college tuition. Please see the article elsewhere in
the FAQ for more details.
If your Savings Bonds are lost, stolen, mutilated, or destroyed, give
prompt notice of the facts to the Department of the Treasury, Bureau of
the Public Dept, Parkersburg, WV 26106-1328, and a list, if possible, of
the serial numbers (with prefix and suffix letters), the issue dates
(month and year) and the denominations of the bonds. Show all names and
addressed that could have appeared on the bonds, along with the owner's
Social Security number, and whether the bond numbers and issue dates are
known. The more information that you are able to provide, the quicker
the Treasury will be able to replace your bonds.
Before describing the specific conditions that apply to Series EE bonds
issued on various dates, it's important to understand the terminology
that is used in these explanations. The following list should help.
Warning: this gets complicated quickly, thanks to your friends at the US
Treasury.
* Issue date: The first day of the month of purchase. Shown on the
face of the bond. (The bond face may also show the date on which
the Treasury processed an application and printed the bond, but
that's not the issue date.)
* Nominal original maturity (date): The date at which a Series EE
Bond reaches its face value. The applicable rates need only exceed
the guaranteed rate (see below) by a small amount for the actual
original maturity date to occur earlier than the nominal first
date.
For Series EE Bonds issued prior to 1 May 1995, the actual first
maturity date depends on the minimum guaranteed rate of interest
that prevails during its life! This period (date) ranges from 9 yrs
8 months for bonds issued prior to 11/86 to 18 years for those
issued since the guaranteed rate was lowered to 4% in 1994. For
bonds purchased prior to 1 Dec 1985, the nominal original maturity
date will be the stated interest rate on the bond divided into 72.
Over the years that date varied from 9 yrs. 6 months to 12 years.
that means minimum guaranteed rates of 6 to 7.5%, except for the
oldest E bonds whose rates (for those still not having reached
final maturity) can be as low as 4%.
* Final maturity (date): the date following which the bond no longer
earns any interest (see discussion above about cashing bonds before
this date).
* Guaranteed minimum rate during original maturity: the minimum
interest rate that the US treasury will pay you on the bonds, no
matter what the market rate may be. This can either be stated as
an interest rate (from which the nominal original maturity date can
be calculated) or as a nominal original maturity date (from which
the minimum guaranteed rate can be calculated). Note that the
Treasury states this guaranteed minimum rate as the overall yield
from issuance, not as the minimum rate for each six-month period.
For example, if a bond paid 8% for some period of time but the
overall guaranteed yield is 4%, then depending on interest rates
and markets, the bond might pay just 1% for some six-month periods
without violating the minimum-rate guarantee.
* Crediting of interest: Prior to 1 May 1995, interest was credited
monthly, and calculated to the first day of the month you cash it
in (up to 30 months, and to the previous 6 month interval after).
Bonds issued after 1 May 1995 and all earlier bonds entering any
extended maturity period after 1 May 1995 will only earn interest
from that point on every six months. For bonds issued after 1 May
1995 or for earlier bonds entering any extended maturity period
after that date, you cash them as soon as possible after any 6
month anniversary date, because cashing a bond any time between any
two 6th month anniversary dates loses all interest since the last 6
month anniversary date.
The following list attempts to clarify the rules that apply to Series E
or EE Bonds that were issued in various time periods. Note that the
rule changes generally change the game only for bonds that are issued
after the rule change. Outstanding Series E Bonds and Savings Notes as
well as Series EE Bonds issued in general continue to earn interest
unter the terms of their original offerings, even as they enter
extension periods.
* Series E bonds issued before 1980
These bonds are very similar to EE bonds, except they were
purchased at 75% of face value. Everything else stated here about
EE bonds applies also to E bonds.
* Series EE Savings bonds issued 1 November 1982 -- 31 October 1986
These bonds have a minimum rate of 7.5% through their maturity
period of 9 yrs 7 mos. If these bonds entered a period of extended
maturity prior to March 1993, they would earn the prevailing market
based rates, or a minimum of the 6.0% guaranteed rate until the
next extended maturity period begins. If these bonds enter a
period of extended maturity after March 1993, they will earn the
prevailing market based rates, or at least the minimum 4.0%
guaranteed rate for the remainder of their life.
* Series EE Savings bonds issued 1 November 1986 -- 28 February 1993
The bonds are subject to the same rules discussed earlier; i.e.,
they earn the 6% guaranteed rate until they reach face value (which
may be before their 12th anniversary depending on prevailing
rates), after which they will earn the prevailing market based
rates, or at least the minimum 4.0% guaranteed rate for the
remainder of their life.
* Series EE Savings bonds issued 1 March 1993 -- 30 April 1995
If held at least 5 years, these bonds have a minimum rate of 4%,
and this rate is guaranteed through their original maturity of 18
years. These EE bonds will earn a flat 4% through the first 5
years rather than the short-term rate, and the interest will accrue
semiannually. Any bond issued before 1 May 1995 will earn a
minimum of 4% after it enters its next extended maturity period.
* Series EE Savings bonds issued 1 May 1995 -- 30 April 1997
These bonds will earn market-based rates from purchase through
original maturity. They will earn the short-term rate for the
first five years after purchase and will earn the long-term rate
from the fifth through the seventeenth year. The bonds will
continue to earn interest after 17 years for a total of 30 years at
the rates then in effect for extensions. If the market-based rates
are not sufficient for a bond to reach face value in 17 years, the
Treasury will make a one-time adjustment to increase it to face
value at that time. Therefore, you are guaranteed that a bond will
be worth its face value as of 17 years of its purchase date. This
equates to a minimum interest rate of 4.1%. If the market-based
rates are higher than this, the bond will be worth more than its
face value after 17 years.
The short-term rate is 85% of the average of six-month Treasury
security yields. A new rate is announced and becomes effective
each May 1 and November 1. The May 1 rate reflects market yields
during the preceding February, March, and April. The November 1
rate reflects market yields during the preceding August, September,
and October.
The long-term rate is 85% of the average of five-year Treasury
security yields. A new rate is announced and becomes effective
each May 1 and November 1. The May 1 rate reflects market yields
during the preceding November through April and the November 1 rate
reflects market yields during the preceding May through October.
Effective 1 May 1995:
The short-term rate is 5.25%
The long-term rate is 6.31%
Interest will be added to the value of the bonds every six months.
Bonds will increase in value six months after purchase and every
six months thereafter. For example, a bond purchased in June will
increase in value on December 1 and on each following June 1 and
December 1. When investors cash their bonds they will receive the
value of the bond as of the last date interest was added. If an
investor redeems a savings bond between scheduled interest dates
the investor will not receive interest for the partial period.
* Series EE Savings bonds issued 1 May 1997 -- present
The latest Treasury program made three significant changes to the
prior system. First, the market rates on which the savings bond
rate are calculated will be long-term rates, rather than a
combination of short-term and long-term rates. Second, all bonds
will earn 90 percent of the average market rate on 5-year Treasury
notes. (This ends the two-tier system that was in place since
1995, as described above.) Finally, interest on savings bonds will
accrue monthly, instead of every six months. This will eliminate
the problem of an investor losing up to five months interest by
redeeming a savings bond at the wrong time. But of course there's
a catch. To encourage longer term holdings of savings bonds, a
three-month interest penalty is imposed if a savings bond is
redeemed within the first five years.
Finally, we'll try to summarize the preceding discussion in a table.
Nom. orig. Final Guar min rate Interest
Issue date maturity maturity orig. maturity credited
before Nov ? yrs 40 yrs ?.?% monthly
1965
1 Nov 1982 9 yrs 7 mos 30 yrs 7.5% monthly
31 Oct 1986
1 Nov 1986 12 yrs 30 yrs 6.0% monthly
28 Feb 1993
1 Mar 1993 18 yrs 30 yrs 4.0% monthly
30 Apr 1995
1 May 1995 17 yrs 30 yrs 4.1% biannually
30 Apr 1997
1 May 1997 TBD 30 yrs TBD% monthly
For current rates, you may call 1-800-4US-Bonds (1-800-487-2663) within
the US. You can call any Federal Reserve Bank to request redemption
tables for US Savings Bonds. You may also request the tables from The
Bureau of Public Debt, Bonds Div., Parkersburg, WV 26106-1328.
Here a few web resources that may help.
* The official US Savings Bonds web site offers a huge amount of
information, as well as a way to purchase Series EE (denominations
50 to 1000) and I Bonds (denominations 50 to 500) with a visa or
master card. This web site can also help you calculate the Current
Redemption Value (CRV) of any bond.
http://www.savingsbonds.gov
* The Treasury's Bureau of the Public Debt maintains another
government web site with comprehensive information about savings
bonds (includes information about branches of the Federal Reserve
Bank):
www.publicdebt.treas.gov .
* The Savings bond Wizard help you manage your own Savings Bond
inventory. It's a PC program, available free of charge:
http://www.savingsbonds.gov/sav/savwizar.htm
* Another site that offers assistance with savings bond issues:
http://www.savingsbonds.com
[ Compiler's note: These disgustingly complex regulations come from many
of the same people who developed the US Tax Code. See any
similarities?? Sheesh! ]
--------------------Check http://invest-faq.com/ for updates------------------
Subject: Bonds - U.S. Savings Bonds for Education
Last-Revised: 27 Aug 2001
Contributed-By: Jackie Brahney (info at savingsbonds.com)
You can use your U.S. Savings Bonds towards your child's education and
exclude all the interest earned from your federal income. This is
sometimes known as the Tax Free Interest for Education program. Here
are some basics on how the Education Savings Bond program works.
You can exclude all or a portion of the interest earned from savings
bonds from your federal income tax. Qualified higher education
expenses, incurred by the taxpayer, the taxpayers spouse or the
taxpayer's dependent at a institution or State tuition plans (see below)
have to incur in the same calendar year the bonds are cashed in.
The following qualifications and exclusions apply.
1. Only Series EE or I Bonds issued in 1990 and later apply; "Older"
bonds cannot be exchanged towards newer bonds.
2. When purchasing bonds to be used for education, you do NOT have to
declare that at the time of purchase that will be using them for
education purposes.
3. You can choose NOT to use the bonds for education if you so choose
at a later date.
4. You must be at least 24 years old when you purchase(d) the bonds.
5. When using bonds for a child's education, register the bonds in
your name, NOT the child's name.
6. A child CAN NOT be listed as a CO-OWNER on the bond.
7. The child can be a beneficiary on the bond and the education
exclusion can still apply.
8. If you are married, a joint return MUST be filed to qualify for the
education exclusion.
9. You are required to report both the principal and the interest from
the bonds to pay for qualified expenses
10. Use Form 8815 to exclude interest for college tuition.
Here are a few frequently asked questions.
Does everyone in every income bracket qualify?
No. The interest exclusion at the highest level is available to
married couples (who file jointly) starting at $83,650 with a
modified gross income and is eliminated at $113,650 or more in tax
year 2001. For single filers, the exclusion begins to reduce at
$55,750 and is eliminated at $70,750 or more in tax year 2001.
These income limitations apply to the year you use the bonds, and
NOT when you purchase the bonds.
What Institutions Qualify for the Exclusion?
Post secondary institutions, colleges, universities, and various
vocational schools. The schools qualify must participate in
federally assisted programs (ex. They offer a guaranteed student
loan program). Beauty or secretarial schools and proprietary
institutions usually do not apply.
What are Qualified Expenses?
Tuition and fees, for any course or educational program that
involves sports, games or hobbies, lab fees and other required
course expenses that relate to an educational degree or
certificate-granting program. These expenses must be incurred
during the same tax year in which the bonds are cashed in. Note:
Room/board expenses, books, and expendable materials (pens,
notepads, etc.) do not qualify.
A bit of advice: when purchasing bonds that you think will be used for
educational purposes, purchase them in small denominations. That way
you won't have to cash in more bonds than are necessary to pay the
current college tuition expenses. Remember, any excess monies you
receive from cashing in some savings bonds that EXCEED the tuition bills
may create a taxable event when you file your federal tax return.
(Savings Bonds are always exempt from State and Local/City taxes.)
Here are some resources on the web that can help.
* The Treasury Department's web site:
http://www.savingsbonds.gov/sav/savedfaq.htm
* The bond experts at SavingsBonds.com:
http:/www.savingsbonds.com
--------------------Check http://invest-faq.com/ for updates------------------
Subject: Bonds - Value of U.S. Treasury Bills
Last-Revised: 24 Oct 1994
Contributed-By: Dave Barrett
The current value of a U.S. Treasury Bill can be found using the Wall
Street Journal. Look in the WSJ in the issue dated the next business
day after the valuation date you want, specifically in the "Money and
Investing" section under the headline "Treasury Bonds, Notes, and
Bills". There you need to look for the column titled "TREASURY BILLS".
Scan down the column for the maturity date of your bill. Then examine
the "Bid" and "Days to Mat." values. The necessary formula:
Current value = (1 - ("Bid" / 100 * "Days to Mat." / 360)) * Mature
Value
For example, a 13-week treasury bill purchased at the auction on Monday
June 21 appears in the June 22, 1994 WSJ in boldface as maturing on
September 22, 1994 with an "Asked" of 4.18 and 91 "Days to Mat.". Its
selling price on Wedesday August 31, 1994 appeared in the September 1,
1994 Wall Street Journal as 20 "Days to Mat." with 4.53 "Bid". A
$10,000 bill would sell for:
(1 - 4.53/100 * 20/360) * $10,000 = $ 9,974.83
minus any brokerage fee.
The coupon yield for a U.S. Treasury Bill is listed as "Ask Yld." in
the Wall Street Journal under "Treasury Bonds, Notes and Bills". The
value is computed using the formula:
couponYield = 365 / (360/discount - daysToMaturity/100)
Discount is listed under the "Asked" column, and "couponYield" is shown
under the "Ask Yld." column. For example, the October 21, 1994 WSJ
lists Jan 19, '95 bills as having 87 "Days to Mat.", and an "Asked"
discount as 4.98. This gives:
365 / (360/4.98 - 87/100) = 5.11%
which is shown under the "Ask Yld." column for the same issue.
DaysToMaturity for 13-week, 26-week, and 52-week bills will be 91, 182,
and 364, respectively, on the day the bill is issued.
--------------------Check http://invest-faq.com/ for updates------------------
Subject: Bonds - Zero-Coupon
Last-Revised: 28 Feb 1994
Contributed-By: Art Kamlet (artkamlet at aol.com)
Not too many years ago every bond had coupons attached to it. Every so
often, usually every 6 months, bond owners would take a scissors to the
bond, clip out the coupon, and present the coupon to the bond issuer or
to a bank for payment. Those were "bearer bonds" meaning the bearer
(the person who had physical possession of the bond) owned it. Today,
many bonds are issued as "registered" which means even if you don't get
to touch the actual bond at all, it will be registered in your name and
interest will be mailed to you every 6 months. It is not too common to
see such coupons. Registered bonds will not generally have coupons, but
may still pay interest each year. It's sort of like the issuer is
clipping the coupons for you and mailing you a check. But if they pay
interest periodically, they are still called Coupon Bonds, just as if
the coupons were attached.
When the bond matures, the issuer redeems the bond and pays you the face
amount. You may have paid $1000 for the bond 20 years ago and you have
received interest every 6 months for the last 20 years, and you now
redeem the matured bond for $1000.
A Zero-coupon bond has no coupons and there is no interest paid.
But at maturity, the issuer promises to redeem the bond at face value.
Obviously, the original cost of a $1000 bond is much less than $1000.
The actual price depends on: a) the holding period -- the number of
years to maturity, b) the prevailing interest rates, and c) the risk
involved (with the bond issuer).
Taxes: Even though the bond holder does not receive any interest while
holding zeroes, in the US the IRS requires that you "impute" an annual
interest income and report this income each year. Usually, the issuer
will send you a Form 1099-OID (Original Issue Discount) which lists the
imputed interest and which should be reported like any other interest
you receive. There is also an IRS publication covering imputed interest
on Original Issue Discount instruments.
For capital gains purposes, the imputed interest you earned between the
time you acquired and the time you sold or redeemed the bond is added to
your cost basis. If you held the bond continually from the time it was
issued until it matured, you will generally not have any gain or loss.
Zeroes tend to be more susceptible to prevailing interest rates, and
some people buy zeroes hoping to get capital gains when interest rates
drop. There is high leverage. If rates go up, they can always hold
them.
Zeroes sometimes pay a better rate than coupon bonds (whether registered
or not). When a zero is bought for a tax deferred account, such as an
IRA, the imputed interest does not have to be reported as income, so the
paperwork is lessened.
Both corporate and municipalities issue zeroes, and imputed interest on
municipals is tax-free in the same way coupon interest on municipals is.
(The zero could be subject to AMT).
Some marketeers have created their own zeroes, starting with coupon
bonds, by clipping all the coupons and selling the bond less the coupons
as one product -- very much like a zero -- and the coupons as another
product. Even US Treasuries can be split into two products to form a
zero US Treasury.
There are other products which are combinations of zeroes and regular
bonds. For example, a bond may be a zero for the first five years of
its life, and pay a stated interest rate thereafter. It will be treated
as an OID instrument while it pays no interest.
(Note: The "no interest" must be part of the original offering; if a
cumulative instrument intends to pay interest but defaults, that does
not make this a zero and does not cause imputed interest to be
calculated.)
Like other bonds, some zeroes might be callable by the issuer (they are
redeemed) prior to maturity, at a stated price.
--------------------Check http://invest-faq.com/ for updates------------------
Subject: CDs - Basics
Last-Revised: 15 Mar 2003
Contributed-By: Chris Lott ( contact me )
A CD in the world of personal finance is not a compact disc but a
certificate of deposit. You buy a CD from a bank or savings & loan for
some amount of money, and the bank promises to pay you a fixed interest
rate on that money for a fixed term. For example, you might buy a
30-month CD paying 3% in the amount of $5,000. A bank may have a
minimum amount for issuing CDs like $1,000, but there is usually no
requirement to buy a CD with an even amount. Interest earned by a CD
may be paid monthly, quarterly, annually, or when the CD matures.
Interest paid during the CD's term is paid by check or deposited to
another account; it is never added to the amount of the CD (like in a
savings account), because the CD amount is fixed.
After you have purchased a CD, you can always redeem it before the
stated maturity date. However, if you cash out early, the bank will
impose a penalty in the amount of 3 or 6-months of interest payments,
depending on the term. This "penalty for early withdrawal" is due
whether any interest was paid or not.
As the name implies, a CD is usually a piece of paper (the certificate)
that states the interest rate and term (actually the maturity date).
Because CDs are issued by banks, a CD for less than $100,000 is insured
by the government (probably the FDIC program), so the investment is
essentially risk-free.
Some CDs can be bought and sold much like a stock or bond. If you buy a
CD through a brokerage house, you may be able to re-sell the CD through
them to avoid paying an early withdrawal penalty. These CDs usually
have significant minimum investment amounts (like $5,000) and require
round numbers (like multiples of 1,000).
--------------------Check http://invest-faq.com/ for updates------------------
Subject: CDs - Market Index Linked
Last-Revised: 15 Mar 2003
Contributed-By: Chris Lott ( contact me )
A market index linked CD (MILC) is a combination of a CD and a
stock-market investment. These instruments seek to add the possibility
of great returns to the security of CDs. They do this by pegging the
interest rate paid by the CD to the performance of some stock-market
index (i.e., they are linked to a market index). The term on these
instrument is usually around 5 years.
Like a conventional CD, the principal is fully insured by the federal
government, so an investor is guaranteed to receive 100% of the original
investment if the CD is held to maturity. Early withdrawal is possible,
but frequently constrained to certain dates each year. Further, an
investor is not guaranteed to receive 100% of the initial investment if
withdrawn early.
All interest is paid when the CD matures. However, there is no
guarantee that any interest will be paid. So there is very little
chance an investor will do very well, but there is a reasonable chance
of doing better than a conventional fixed-rate CD.
These notes have a quirky tax treatment. Although they pay no interest
annually, if the CD is held in a regular account, an investor must
nonetheless declare income from a market index linked CD every year. So
you're probably asking, the thing paid me nothing, what am I declaring!?
The amount to declare is based on the amount a comparable, conventional
CD of the same term would pay, based on information in the MILC. These
declared payments are added to the cost basis of the CD and the whole
mess is reconciled when the CD matures. Investors can avoid this hassle
by holding this instrument in a tax-deferred account such as an IRA.
--------------------Check http://invest-faq.com/ for updates------------------
Subject: Derivatives - Basics
Last-Revised: 6 Dec 1996
Contributed-By: Brian Hird, Chris Lott ( contact me )
A derivative is a financial instrument that does not constitute
ownership, but a promise to convey ownership. Examples are options and
futures. The most simple example is a call option on a stock. In the
case of a call option, the risk is that the person who writes the call
(sells it and assumes the risk) may not be in business to live up to
their promise when the time comes. In standarized options sold through
the Options Clearing House, there are supposed to be sufficient
safeguards for the small investor against this.
Before discussing derivatives, it's important to describe their basis.
All derivatives are based on some underlying cash product. These "cash"
products are:
* Spot Foreign Exchange. This is the buying and selling of foreign
currency at the exchange rates that you see quoted on the news. As
these rates change relative to your "home currency" (dollars if you
are in the US), so you make or lose money.
* Commodities. These include grain, pork bellies, coffee beans,
orange juice, etc.
* Equities (termed "stocks" in the US)
* Bonds of various different varieties (e.g., they may be Eurobonds,
domestic bonds, fixed interest / floating rate notes, etc.). Bonds
are medium to long-term negotiable debt securities issued by
governments, government agencies, federal bodies (states),
supra-national organisations such as the World Bank, and companies.
Negotiable means that they may be freely traded without reference
to the issuer of the security. That they are debt securities means
that in the event that the company goes bankrupt. bond-holders
will be repaid their debt in full before the holders of
unsecuritised debt get any of their principal back.
* Short term ("money market") negotiable debt securities such as
T-Bills (issued by governments), Commercial Paper (issued by
companies) or Bankers Acceptances. These are much like bonds,
differing mainly in their maturity "Short" term is usually defined
as being up to 1 year in maturity. "Medium term" is commonly taken
to mean form 1 to 5 years in maturity, and "long term" anything
above that.
* Over the Counter ("OTC") money market products such as loans /
deposits. These products are based upon borrowing or lending.
They are known as "over the counter" because each trade is an
individual contract between the 2 counterparties making the trade.
They are neither negotiable nor securitised. Hence if I lend your
company money, I cannot trade that loan contract to someone else
without your prior consent. Additionally if you default, I will
not get paid until holders of your company's debt securities are
repaid in full. I will however, be paid in full before the equity
holders see a penny. Derivative products are contracts which have
been constructed based on one of the "cash" products described above.
Examples of these products include options and futures. Futures are
commonly available in the following flavours (defined by the underlying
"cash" product):
* commodity futures
* stock index futures
* interest rate futures (including deposit futures, bill futures and
government bond futures) For more information on futures, please
see the article in this FAQ on futures.
In the early 1990s, derivatives and their use by various large
institutions became quite a hot topic, especially to regulatory
agencies. What really concerns regulators is the fact that big banks
swap all kinds of promises all the time, like interest rate swaps,
froward currency swaps, options on futures, etc. They try to balance
all these promises (hedging), but there is the big danger that one big
player will go bankrupt and leave lots of people holding worthless
promises. Such a collapse could cascade, as more and more speculators
(banks) cannot meet their obligations because they were counting on the
defaulted contract to protect them from losses.
All of this is done off the books, so there is no total on how much
exposure each bank has under a specific scenario. Some of the more
complicated derivatives try to simulate a specific event by tracking it
with other events (that will usually go in the same or the opposite
direction). Examples are buying Japan stocks to protect against a loss
in the US. However, if the usual correlation changes, big losses can be
the result.
The big danger with the big banks is that while they can use derivatives
to hedge risk, they can also use them as a way of taking ON risk. Not
that risk is bad. Risk is how a bank makes money; for example, issuing
loans is a risk. However, banks are forbidden from taking on risk with
derivatives. It's just too easy for a bank to hedge bonds with
derivatives that don't have the same maturity, same underlying security,
etc. so the correlation between the hedge and the risky position is
weak.
--------------------Check http://invest-faq.com/ for updates------------------
Compilation Copyright (c) 2003 by Christopher Lott.

User Contributions:

My employer accidentally advised the company handling the 401k investment that I had been terminated, when in fact I had not. As a result, withdrawals discontinued from my pay and I missed a couple years of contributions. Since I never withdrew from the plan, is my employer liable for making up these contributions? If I made a lump sum catchup contribution,could they do the same?

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